Kendor P. Jones Jennifer L. McDowell Welborn Sullivan Meck & Tooley, P.C. Denver, Colorado. Synopsis

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1 Chapter 23 KEEPING YOUR LEASE ALIVE IN GOOD TIMES AND IN BAD Kendor P. Jones Jennifer L. McDowell Welborn Sullivan Meck & Tooley, P.C. Denver, Colorado Synopsis Introduction Preserving the Lease During the Primary Term [1] Delay Rentals [2] Obtaining Production [3] Coalbed Methane Wells Preserving the Lease into the Secondary Term [1] Commencement of Operations [2] Pooling/Unitization [3] Force Majeure Maintaining the Lease During the Secondary Term [1] Dry Hole and Cessation of Production Clauses [2] Shut-In Royalties [3] Notice Requirement Keeping the Lease Alive by Developing the Leasehold [1] Express Covenant to Develop [2] Implied Covenant for Further Development [a] Development of Deeper Formations [b] Statutory Requirements to Develop [c] Notice Requirement [3] Implied Covenant of Further Exploration [4] Unconventional Gas Plays Conclusion 23-1

2 23-2 Mineral Law Institute Introduction * The oil and gas lease is the central document in oil and gas development. By issuing a lease, the mineral owner transfers the right to explore for and develop its minerals to the lessee. Both parties expect to make a profit from the transaction, but their means for achieving this end may be different. The lessor wishes to maximize the upfront bonus and royalty to be paid, minimize the length of the primary term, and require diligent development of the leasehold once production has been obtained. The lessee, on the other hand, seeks the right to develop for the agreed upon term, without the obligation to develop during such term, and, once production is obtained, to maintain the lease for so long as it can do so at a profit, without interference from the lessor. This chapter will focus on these conflicting goals. A great deal has been written about lease maintenance issues during the last twenty years, 1 primarily during periods of industry downturns. This may be coincidental, or it may be a reflection that maintaining lease inventory is particularly difficult in periods of weak market conditions when financial challenges prevent lessors from drilling and developing their leases to the extent desired (or required). At the time this chapter was written, the industry was experiencing another downturn, with uneconomic wells shut in, drilling in certain areas all but stopped, and royalty payments greatly diminished all precursors to lease challenges down the road. But it should also be noted that lease maintenance issues are not unique to industry depressions, as evidenced by the widespread top leasing activities and lease busting attempts that characterized the last boom, and it is likely that the short primary terms of many of the leases currently being issued will require prompt drilling activity to hold onto such leases, whether under boom or bust conditions. 2 * Cite as Kendor P. Jones & Jennifer L. McDowell, Keeping Your Lease Alive in Good Times and in Bad, 55 Rocky Mt. Min. L. Inst (2009). 1 Gregory R. Danielson, Lease Maintenance and the Development of Coalbed Methane, 46 Rocky Mt. Min. L. Inst. 8-1 (2000); Bruce M. Kramer, Lease Maintenance for the Twenty-First Century: Old Oil and Gas Law Doesn t Die, It Just Fades Away, 41 Rocky Mt. Min. L. Inst (1995); Thomas P. Battle, Lease Maintenance in the Face of Curtailed/Depressed Markets, 32 Rocky Mt. Min. L. Inst (1986); William P. Pearce, Keeping Oil and Gas Leases Alive: A Review of Both the Mineral Lessee s Obligations and Possible Ways to Keep Leases in Effect, Problems and Opportunities During Hard Times in the Minerals Industry 8-1 (Rocky Mt. Min. L. Fdn. 1986). 2 See Joshua Starnes, To Retain Leases, Shale Operators Keep on Drilling, Platts Gas Daily, June 25, 2009.

3 Keeping the Lease Alive 23-3 Early leases were typically for a fixed term of up to 20 years, sometimes with an option to renew for a second fixed term. 3 In the early 1900s, the modern day habendum clause developed with a relatively short primary term followed by an indefinite secondary term that required the lessee to perform certain activities during both the primary and secondary terms to keep the lease alive. 4 The habendum clause means what it says, i.e., without production in paying quantities (or the commencement of operations to obtain production) at the end of the primary term, the lease terminates. 5 All jurisdictions, except Oklahoma and Louisiana, treat the habendum clause as creating a fee simple determinable that terminates automatically upon the failure of one or more of the conditions on which it is based. 6 Equitable remedies, such as waiver and estoppel, are generally not available to avoid termination. 7 To ameliorate the harshness of the automatic termination rule, lessees have drafted oil and gas leases that include savings clauses, which serve as substitutes for actual production and are designed to keep the lease alive absent production during the primary term (delay rental clause), preserve the lease into the secondary term (commencement of operations, pooling, and force majeure clauses), and maintain the lease during the secondary term if production is not obtained from the initial well or ceases thereafter or if the product is not immediately marketed (dry hole, cessation of production, and shut-in royalty clauses). Certain savings clauses can be utilized during both the primary and secondary terms (e.g., dry hole, cessation of production and shut-in royalty clauses) to preserve the lease. The fail-safe clause is one that requires a notice of default and a reasonable period of time to cure the default before the lease is terminated. 3 The lease under which America s first well was drilled, the Drake well in 1859, provided for a term of 15 years, with the privilege of renewal for the same term. See Leslie Moses, The Evolution and Development of the Oil and Gas Lease, 2 Sw. Legal Fdn. Oil & Gas Institute 1, 7 (1951). 4 Martin & Kramer, 3 Williams & Meyers Oil and Gas Law (2008) (Williams and Meyers). 5 Gulf Oil Corp. v. Reid, 337 S.W.2d 267, 269 (Tex. 1960); Woodside v. Lee, 81 N.W.2d 745, 746 (N.D. 1957). 6 See, e.g., Texas Co. v. Davis, 254 S.W. 304, 309 (Tex. 1923). Oklahoma has rejected the fee simple determinable interpretation of the habendum clause. See Stewart v. Amerada Hess Corp., 604 P.2d 854, 858 (Okla. 1979). 7 See Duke v. Sun Oil Co., 320 F.2d 853, 865, n.19 (5th Cir. 1963) and Phillips Petroleum Co. v. Curtis, 182 F.2d 122 (10th Cir. 1950). But see Jicarilla Apache Tribe v. Andrus, 687 F.2d 1324 (10th Cir. 1982) and Humble Oil & Refining Co. v. Harrison, 205 S.W.2d 355 (Tex. 1947).

4 23-4 Mineral Law Institute Even if production has been obtained, either from a well on the leased premises or on lands pooled therewith, and the lease has been extended beyond the primary term, the lessee cannot relax since almost all jurisdictions hold that there is an implied covenant of further development that requires the lessee to act with reasonable diligence in developing the lease, as would a prudent operator under similar circumstances, in order to keep the lease alive as to the undeveloped leasehold. 8 Court-imposed remedies for breach of this implied covenant to develop vary, from an award of damages to conditional or immediate cancellation of the lease as to the undeveloped portion of the lands. Sections to of this chapter analyze the various types of savings clauses that can be used during the life of the lease and discuss court decisions that have interpreted such clauses and have expanded or narrowed their scope, while section addresses the implied covenant to develop the leasehold once production has been obtained and reviews current industry practices for unconventional gas plays that may alter the way the courts view this implied covenant Preserving the Lease During the Primary Term [1] Delay Rentals Many modern oil and gas leases are paid up leases, which means that the mineral owner is given an up-front payment, equivalent to the rentals payable for the entire primary term, instead of receiving yearly rental payments throughout the primary term. If the lease is not paid up, then the lessee must pay the mineral owner annual rental payments in compliance with the lease terms or risk having the lease automatically terminate. These annual payments are called delay rentals because payment of the rental keeps the lease alive and allows the lessee to delay drilling a well for another year. Of course, the lessee can extend the lease by drilling or commencing operations, which has the small added benefit of avoiding the delay rental payments (normally, not that significant). Most modern leases contain an unless form of delay rental clause, which provides that if there is not a producing well on the leased premises or on lands pooled therewith, or if operations have not been commenced to drill a well on the premises or on lands pooled therewith, the lease will automatically terminate unless on or before the first anniversary date of the lease the lessee pays the specified rental in the specified manner, thereby deferring commencement of drilling operations for another 12 8 See Superior Oil Co. v. Devon Corp., 604 F.2d 1063, 1068 (8th Cir. 1979).

5 Keeping the Lease Alive 23-5 months. 9 The unless rental clause is so worded that although the lessee may defer drilling and extend the lease by paying delay rentals, there is no obligation to drill or requirement to pay. If the lessee chooses not to pay or drill, the lease automatically terminates. In contrast, under the alternative form of an or delay rental clause, which is still widely used in the West Coast and Appalachian states, the lessee is obligated to either drill a well, pay delay rentals, or surrender the lease. If the lessee does not surrender the lease and it fails to either drill or pay, the lease is not automatically terminated, but the lessee is subject to a breach of contract action for its failure to make the delay rental payment. 10 All states, even Oklahoma, require strict compliance with the delay rental provision. 11 Tardiness in paying rentals is inexcusable, even when dire circumstances exist. 12 Importantly, a delay rental clause will not keep the lease alive when (1) operations lead to a dry hole or production ceases during the primary term and (2) there is no provision in the lease for a return to payment of delay rentals. 13 Even if there is a provision allowing for the return to rental payments, it may be unclear when such payments are due. For example, Superior Oil Co. v. Stanolind Oil & Gas Co., 14 involved a dispute as to whether, after a dry hole was drilled in the primary term, the delay rentals were due prior to the anniversary of the lease or the anniversary of the dry hole. The Superior lease provided: Should the first well drilled on the above described lands be a dry hole, then and in that event if a second well is not commenced on said land within twelve months thereafter, this lease shall terminate as to both parties, unless 9 See Schwartzenberger v. Hunt Trust Estate, 244 N.W.2d 711 (N.D. 1976), and Phillips Petroleum Co. v. Curtis, 182 F.2d 122 (10th Cir. 1950) for an analysis of the unless lease. 10 See Warner v. Haught, Inc., 329 S.E.2d 88 (W.Va. 1985) and Butler v. Nepple, 354 P.2d 239 (Cal. 1960). 11 See Phillips Petroleum Co. v. Curtis, 182 F.2d 122 (10th Cir. 1950); Danne v. Texaco Exploration & Prod., Inc., 883 P.2d 210 (Okla. App. 1994). 12 See Ford v. Cochran, 223 S.W (Tex. App. 1920) (no excuse for missing payment to be with sick relative). But see Borth v. Gulf Oil Exploration and Production Co., 313 N.W.2d 706 (N.D. 1981) (equitable adjustment made by reducing the leasehold by the percentages that rentals actually paid bore to rentals required to be paid); and Humble Oil & Refining Co. v. Harrison, 205 S.W.2d 355 (Tex. 1947) (lessor estopped to assert lease was terminated by erroneous delay rental payment because of an ambiguous mineral deed). 13 Davis v. Laster, 138 So.2d 558, 562 (La. 1962) ( rental payments... are designed only to grant the privilege of deferring commencement of drilling operations ). But see Colby v. Sun Oil Co., 288 S.W.2d 221 (Tex. App. 1956) (completion of dry hole precludes further rental payments, thereby making the leasehold indefeasible during the primary term) S.W.2d 346 (Tex. App. 1950), aff d, 240 S.W.2d 281 (Tex. 1951).

6 23-6 Mineral Law Institute the lessee on or before the expiration of said twelve months, shall resume the payment of rentals in the same amount and in the same manner as hereinbefore provided The Texas Court of Appeals affirmed the trial court s finding that the lease unambiguously required that after the dry hole was drilled, delay rentals be paid on the anniversary date of the dry hole, not on the anniversary of the date that the parties entered into the lease. In affirming the court of appeals, a majority of the Texas Supreme Court found the lease to be ambiguous as to when rental was due, but reasoned that Superior s predecessor-in-interest had paid the delay rentals on the anniversary date of the dry hole for the three years previous to Superior acquiring the lease, and that Superior had knowledge of these payments. Bankruptcy is no relief from the harsh rule. An oil and gas lease will terminate automatically when a bankruptcy trustee fails to make a timely delay rental payment and neither the Bankruptcy Code nor the bankruptcy court can prevent such termination. 15 [2] Obtaining Production Production during the primary term preserves the lease. But what does the term production mean? The courts have held that the word produce as used in the habendum clause of an oil and gas lease is synonymous with the phrase producing in paying quantities. 16 A well is producing in paying quantities if the production is sufficient to pay the lessee a profit, even small, over the operating and marketing expenses, although the cost of drilling may never be repaid. 17 The majority of states require actual production (also referred to as discovery, plus marketing). 18 A few states, Oklahoma being the leading example, are discovery jurisdictions and only require that the well be capable of producing in paying quantities. 19 Even the Oklahoma courts patience has its limits, however, and in a Id. at In re Trigg, 630 F.2d 1370 (10th Cir. 1980). See also In re J.H. Land & Cattle Co. Inc., 8 B.R. 237, 239 (W.D. Okla. 1981) (debtor-lessor allowed to reject 11 leases and grant new leases on more advantageous terms under business judgment test ). 16 Garcia v. King, 164 S.W.2d 509, (Tex. 1942). 17 Id. 18 Gulf Oil Corp. v. Reid, 337 S.W.2d 267, (Tex. 1960) (must be actual production and marketing to have production in paying quantities). See also Davis v. Cramer, 808 P.2d 358, 363 (Colo. 1991) (implied covenant to market applies during primary term and the lease expired because lessee did not pay shut-in royalties or market production during the primary term). 19 Pack v. Santa Fe Minerals, 869 P.2d 323, 326 (Okla. 1994).

7 Keeping the Lease Alive 23-7 decision, Geyer Bros. Equipment Co. v. Standard Resources, LLC, 20 the Oklahoma Court of Appeals ruled that the lease expired even though the well was capable of producing in paying quantities. The Geyer lessee had failed to produce or market the gas for over 20 years after drilling the well. Although there was no pipeline to service the well, the lessee made no efforts to obtain a pipeline and waited five years after being locked out from entering the property before attempting to assert its rights. In the end, the court ruled that the lease terminated because the lessee had failed to market the gas for an unreasonable period. Specific lease terms can lead to unusual results. For example, in determining the production required to continue a lease during the secondary term, Texas courts have recognized a distinction between the typical production in paying quantities habendum clause and one that provides that the lease continues as long as gas is or can be produced. In the latter situation, the courts have held that the lease will continue so long as the well is actually producing or is capable of producing gas. 21 A well is capable of production, at least in the eyes of the Texas courts, if the well is turned on and product can flow without additional equipment or repairs. 22 In a 2008 decision, Blackmon v. XTO Energy, Inc., 23 the Texas Court of Appeals held that when deciding if a well is capable of producing, the issue to be decided is whether the well is capable of producing gas in marketable quantities, not in marketable quality. The plaintiffs argued that the well at issue was not producing in paying quantities because it produced gas that was unmarketable in its raw state and additional equipment was required in order to market the gas. The court held that the required additional equipment was part of the processing function, not the production function, and that the evidence conclusively established that the well was capable of producing in paying quantities because the raw P.3d 563, 567 (Okla. App. 2006). 21 See Grinnell v. Munson, 137 S.W.3d 706 (Tex. App. 2004). 22 Anadarko Petroleum Corp. v. Thompson, 94 S.W.3d 550, 558 (Tex. 2002) (quoting Hydrocarbon Mgt., Inc. v. Tracker Exploration, Inc., 861 S.W.2d 427, (Tex. App. 1993) ( a well would not be capable of producing in paying quantities if the well switch were turned on, and the well did not flow, because of mechanical problems or because the well needs rods, tubing, or pumping equipment )) S.W.3d 600, 603 (Tex. App. 2008).

8 23-8 Mineral Law Institute gas was capable of flowing from the wellhead in a marketable quantity, regardless of whether the processing equipment was installed. 24 The lessor has the burden of proving that the lease is not producing in paying quantities. 25 To prove that a lease is not producing in paying quantities, the lessor must show both that the lease operated at a loss over a reasonable period of time and that a reasonably prudent operator would not continue operating under the circumstances. 26 The court will examine the facts and circumstances of each case, and compelling equitable considerations may save an oil and gas lease from termination even with unprofitable operations. For example, in Barby v. Singer, 27 the Oklahoma Supreme Court held that the prospect of impending federal legislation, the Natural Gas Policy Act, that might result in an increase in the price of natural gas was equitable consideration for preserving the lease. But in Smith v. Marshall Oil Corporation, 28 the same court held that there were not compelling circumstances that justified the continuation of the leases in the face of a cessation of production when the operator testified at trial that during the three-year time period in question, I produced them when I felt like producing them. And I turned them off when I felt like turning them off The court noted that the operator had deliberately ceased production hoping that oil and gas prices would rise, but stated that [f]luctuating market prices do not rise to the level of equitable consideration,... [or excuse a] failure to produce in paying quantities See also Chesapeake Exploration, Ltd. v. Corine Inc., 2007 WL (Tex. App. August 29, 2007) and Wheeler & Lemaster Oil & Gas Co. v. Henley, 398 S.W.2d 475 (Ky. 1965). 25 Coyle v. North American Oil Consol., 9 So.2d 473, 479 (La. 1942); Cox v. Cardinal Drilling Company, 188 So.2d 667, 672 (La. App. 1966). 26 Dreher v. Cassidy Ltd. Partnership, 99 S.W.3d 267, 269 (Tex. App. 2003); Pshigoda v. Texaco, Inc., 703 S.W.2d 416, (Tex. App. 1986). Cf. Positron Energy Resources, Inc. v. Weckbacher, 2009 WL (Ohio App. March 12, 2009) (burden shifts to lessee when it seeks a declaratory judgment that the lease is valid) P.2d 14 (Okla. 1982) P.3d 830 (Okla. 2004) Id. at Id. at 836. See also Somont Oil Co., Inc. v. A & G Drilling, Inc., 49 P.3d 598, 606 (Mont. 2002) (in determining whether production had ceased temporarily, the district court erred by improperly allowing the jury to consider oil and gas prices, economic factors, and the lessee s financial condition).

9 Keeping the Lease Alive 23-9 The reasonable time period must be broad enough to provide an accurate picture of the lease activity. 30 The revenue considered is the working interest revenue prior to the payment of overriding royalties, production payments, or other burdens, except for the lessor s royalty. 31 Expenses deducted are lifting expenses, which are costs associated with producing the oil and gas after the well has been drilled and are the ordinary, periodic, direct operating expenses associated with the lease. One-time expenses, such as drilling, equipping, and reworking costs, are capital expenditures and are not to be considered in determining whether a lease is producing in paying quantities. 32 Even if the strict arithmetic test is not satisfied, the lease may survive if a reasonably prudent operator would have continued to operate the well. 33 Should the court also consider industry conditions in establishing the length of the period to be considered? The Tenth Circuit did in Denker v. Mid-Continent Petroleum Corp., 34 a depression-era case. [3] Coalbed Methane Wells The industry has been anxiously waiting for a court ruling on whether the dewatering of coalbed methane wells constitutes production. To the surprise of many, the issue has not been adjudicated to date. Perhaps one explanation for this is that many of the coalbed methane leases recently issued specifically provide that production includes the dewatering process. For federal leases, agency-wide regulations do not exist regarding dewatering and production. However, at least some Bureau of Land Management jurisdictions will grant an initial paying well determination which will serve to extend the lease as held by production if it appears that 30 Wood v. Axis Energy Corp., 899 So.2d 138, 145 (La. App. 2005) (12 months prior to shut-in); Pshigoda v. Texaco, Inc., 703 S.W.2d 416, (Tex. App. 1986) (court correctly submitted two time periods for jury s consideration two years prior to filing and 17 months between filing and trial). 31 Hininger v. Kaiser, 738 P.2d 137, 140 (Okla. 1987); Clifton v. Koontz, 325 S.W.2d 684, (Tex. 1959). 32 Wood v. Axis Energy Corp., 899 So.2d 138, 145 (La. App. 2005); Smith v. Marshall Oil Corp., 85 P.3d 830 (Okla. 2004); Avien Corp. v. First Nat. Oil, Inc., 79 P.3d 223 (Kan. App. 2003); Abraxas Petroleum Corp. v. Hornburg, 20 S.W.3d 741 (Tex. App. 2000). 33 Clifton v. Koontz, 325 S.W.2d 684 (Tex. 1959); T.W. Phillips Gas and Oil Co. v. Jedlicka, 964 A.2d 13 (Pa. App. 2008) (lessee s good faith is key to determination, not an objective determination whether revenues exceeded expenses each year) F.2d 725 (10th Cir. 1932). See also 3 Williams & Meyers, supra note 4, 604.6(c) ( The lessee has a fairly strong argument for holding the lease by nonpaying production during a period when temporary depression prevents paying production. ).

10 23-10 Mineral Law Institute a prudent operator would continue to operate the coalbed methane well in expectation of improving the well s performance. 35 Beyond the dewatering/production question, coalbed methane wells present unique issues as to whether the well is even capable of production. For example, in Levin v. Maw Oil and Gas, LLC, 36 the issue before the trial court was whether a coalbed methane well that was not connected to either a dewatering system or a gathering system was capable of production. The court held that the well had to be connected to both systems in order to be capable of production Preserving the Lease into the Secondary Term [1] Commencement of Operations Most modern oil and gas leases provide that a lease will not terminate if the lessee commences operations for the drilling of a well on the leased lands or on acreage pooled therewith by the end of the primary term. There are frequent disagreements between lessors and lessees as to what actions constitute commencement of operations. In fact, the courts cannot agree whether a regulatory agency s approval of an application to drill is required for operations to have commenced. 37 Texas courts have defined commencement of operations as requiring a bona fide intent to proceed thereafter with diligence toward the completion of a producing well. 38 In determining whether operations have indeed commenced, the courts consider the specific language of the lease and the facts and circumstances of each case. Substantial surface operations will be sufficient, provided that the preliminary operations are continued and the well is spud. For example, in Breaux v. Apache Oil Corp., 39 the court found that the lessee had commenced operations by completing a board road and turnaround to the well location by the end of the primary term, even though equipment was not moved to the site and drilling operations were not commenced until two days after the primary term ended. Similarly, in Petersen v. Robinson 35 See e.g., Colorado BLM, Notice to Lessee/Operators NTL-CO-88-2, Paying Well Determinations and Venting, and Flaring Applications on Jurisdictional Coal Bed Methane Wells (1988). 36 No. 07 CV 166 (D. Ct. Miami County, Kan., 2007) (decision pending, Kansas Supreme Court Docket No ). 37 Compare Bunnell Farms Co. v. Samuel Gary, Jr. & Assoc., 47 P.3d 804 (Kan. App. 2002), with Gray v. Helmerich & Payne, Inc., 834 S.W.2d 579 (Tex. App. 1992). 38 Bell v. Mitchell Energy Corp., 553 S.W.2d 626, 632 (Tex. App. 1977) (citing Peterson v. Robinson Oil & Gas Company, 356 S.W.2d 217, 220 (Tex. App. 1962)) So.2d 589 (La. App 1970).

11 Keeping the Lease Alive Oil & Gas Co., 40 the court found that drilling operations had commenced because the lessee had hired a contractor, hired a surveyor, completed the survey, staked the well, moved the maintainer onto location, and begun to level the well location. 41 Some courts have distinguished commence drilling operations and commence to drill a well from commence operations for the drilling of a well, holding that the former require the lessee to penetrate the ground with a drill bit prior to the end of the primary term. For example, in Hall v. JFW, Inc., 42 the court found that, even though the well location was staked, elevation survey completed, drilling contractor hired, drilling pits dug, location leveled, and water well dug, drilling had not commenced because actual drilling had not started. 43 By contrast, in Bunnell Farms Co. v. Samuel Gary, Jr. & Assoc., 44 the contractor had drilled 51 feet and had set and cemented casing on the last day of the primary term. A larger rig was moved onto the premises two days after the expiration of the primary term and the well was completed. The lessor argued that drilling had not commenced before the end of the primary term because the original drilling rig was too small to complete the well. The court held that to extend the lease into the secondary term, drilling was required to be commenced but not completed and that the drilling in the instant case was sufficient to commence operations. As with all contracts, the specific lease language is crucial to the determination of whether the lessee s actions have extended the lease beyond the primary term. For example, in Petroleum Energy, Inc. v. Mid- America Petroleum, Inc., 45 the court found that drilling operations had commenced when the dirt contractor prepared the site for drilling because the lease provided that operations shall be deemed to be commenced when the first material is placed on the leased premises or when the first work, other than surveying or staking the location, is done thereon which is necessary for such operations In Veritas Energy, LLC v. Brayton S.W.2d 217 (Tex. App. 1962). 41 See also Vickers v. Peaker, 300 S.W. 2d 29, 32 (Ark. 1957) P.2d 837, 842 (Kan. 1995). 43 See also Solberg v. Sunburst Oil & Gas Co., 235 P. 761 (Mont. 1925). But see LeBar v. Haynie, 552 P.2d 1107 (Wyo. 1976) ( commence to drill a well may be satisfied if preliminary commencement activities are not mere pretenses or a holding device) P.3d 804 (Kan. App. 2002) F. Supp (D. Kan. 1991) Id. at 1423

12 23-12 Mineral Law Institute Operating Corp., 46 on the other hand, operations were found not to have commenced by backdragging of grass because the lease defined operations as for and any of the following: drilling, testing, completing, reworking, recompleting, deepening, plugging back or repairing of a well in search for or in an endeavor to obtain production of oil, gas, sulphur or other minerals The lessee is relieved of the requirement to comply with the commencement of operations clause if the lessor s actions prevent him from taking such action. 47 Once operations are commenced, however, the lessee is required to diligently continue such operations in good faith. 48 Does this requirement extend to completing the well? In the few cases dealing with the requirement of diligent completion, the applicable standard appears to combine an objective standard of diligence and a subjective standard of good faith. 49 Availability of equipment may come into play in applying this standard. In the recent past, frac proponents, mud, tubulars, completion rigs, and the like were in short supply, and the most diligent of operators had a hard time completing a well. [2] Pooling/Unitization Pooling refers to the integration of small tracts and fractional interests into a single spacing unit for the purpose of having sufficient acreage to receive a well drilling permit and for the sharing of production by the interest owners in the pooled unit. 50 Unitization, on the other hand, refers to the joining together of mineral or leasehold interests covering all or part of a common source of supply. 51 While both pooling and WL (Tex. App. February 14, 2008) (memorandum opinion) Id. 47 See Pinnacle Gas Resources v. Diamond Cross Properties, LLC, 201 P.3d 160 (Mont. 2009) (lessor s counsel notified lessee that it had not satisfied statutory notice requirements and it would be a trespasser if it entered onto the leasehold); and Greer v. Carter Oil Co., 25 N.E. 2d 805 (Ill. 1940) (lessor who brought suit to invalidate lease estopped from claiming term had expired). Cf. Stone v. Devon Energy Production Company, 181 P.3d 936 (Wyo. 2008) (assignee breached clause requiring it to make a reassignment offer six months prior to the end of primary term, but the well was drilled within the six month period, so the assignor suffered no damages). 48 Sword v. Rains, 575 F.2d 810 (10th Cir. 1978); LeBar v. Haynie, 552 P.2d 1107, 1111 (Wyo. 1976). 49 See 3 Williams & Meyers, supra note 4, See also Exxon Corporation v. Emerald Oil & Gas Company, L.C., 2009 WL (Tex. March 27, 2009) and Simpson v. Stanolind Oil & Gas Co., 210 F.2d 640, 642 (10th Cir. 1954). 50 Kramer and Martin, The Law of Pooling and Unitization 1.02 (2008) (Kramer and Martin). 51 Id.

13 Keeping the Lease Alive unitization are methods to be used to allow for the orderly and efficient development/conservation of the underlying oil and gas resources, pooling is accomplished in order to drill a single well, while the primary function of unit operations is to maximize production by efficiently draining the reservoir, utilizing the best engineering techniques that are economically feasible. 52 Pooling may be either voluntary or forced under statutes in most producing states (except Kansas) authorizing compulsory pooling. Voluntary pooling may be accomplished by the execution of a pooling agreement among the interest owners or by the lessee s recording of a declaration of pooling under the pooling clause of the lease. 53 If a lease contains a pooling clause and the lessee complies strictly with the terms of such clause, then production from the pooled acreage will act as constructive production to preserve the lease into the secondary term. Certain courts have interpreted the pooling clause as granting very broad pooling authority to the lessee and others have interpreted the pooling clause strictly. 54 All jurisdictions that have addressed the matter apply a standard of good faith to the exercise of the pooling clause. This recognizes that the pooling clause tends to favor the interests of the lessee more than those of the lessor. 55 Pooling after production has been obtained does not, by itself, constitute bad faith, 56 nor does pooling just before the expiration of the primary term. 57 Absent a clause to the contrary, when a lease lies partially within and partly outside a unit, unit production will maintain the lease in its entirety, regardless of the location of the well. 58 This is true regardless of whether the pooled unit has resulted from the exercise of the pooling clause or 52 Id. 53 See Pearce, supra note 1, footnotes , for typical pooling clauses and pooling statutes. 54 Compare Phillips Petroleum Co. v. Peterson, 218 F.2d 926, 933 (10th Cir. 1954) with Jones v. Killingsworth, 403 S.W.2d 325 (Tex. 1966). See also Sunac Petroleum Corp. v. Parkes, 416 S.W.2d 798 (Tex. 1967) (clause allowing pooling for gas purposes only inoperative when oil well drilled). 55 See Amoco Production Co. v. Underwood, 558 S.W.2d 509 (Tex. App. 1977); Southwest Gas Producing Co. v. Seale, 191 So.2d 115 (Miss. 1966); and Imes v. Globe Oil & Refining Co., 84 P.2d 1106 (Okla. 1938). 56 Gillham v. Jenkins, 244 P.2d 291, 293 (Okla. 1952); Kaszar v. Meridian Oil & Gas Enterprises Inc., 499 N.E. 2d 3 (Ohio App. 1985). 57 Boone v. Kerr-McGee Oil Indus., 217 F.2d 63, 65 (10th Cir. 1954). But see Wilcox v. Shell Oil Co., 76 So.2d 416 (La. 1954). 58 Kramer and Martin, 20.02[1].

14 23-14 Mineral Law Institute from creation of the unit by the state conservation agency. 59 The lessor can seek additional development of the acreage outside of the unit through the implied covenant to develop (see 23.05) or by including a Pugh clause in the lease. 60 Several states have enacted statutory Pugh clauses that provide that the term of a lease extended by production in a pooled unit shall not extend to lands outside of the unit. 61 Lessees with leases that are beyond their primary term but are held by production from older fields may face challenges as a result of emerging resource plays that overlap these mature producing fields, as evidenced by the recently decided Cambridge Production, Inc. v. Geodyne Nominee Corp In Cambridge, the top lessor sought termination of 44 oil and gas leases (the Section 33 leases) covering Section 33, Block M-1, H&GN Ry. Survey, Hemphill County, Texas. At the end of the primary terms of the Section 33 leases, there was no production on Section 33. However, the Section 33 leases had been pooled with Section 39, on which a producing well, the Prater 1-39, had been completed in the interval between 14,364 feet and 14, 372 feet. The Designation of Pooling erroneously identified the pooled depths for the well as between 14,634 feet and 14,929 feet. Even though they were not entitled to royalties from the Prater 1-39 well because of the erroneous unit designation, the lessors were paid and accepted royalties on production from such well for 20 years. On cross motions for summary judgment, the trial court held in favor of the lessees, declaring that the Section 33 leases and the unit designations creating the Prater Unit were in full force and effect. The court of appeals affirmed, ruling that the defense of quasi estoppel 61.2 applied since the lessors had accepted the benefit of revenues from production to which they were not entitled, and to repudiate the Section 33 leases would be asserting a right inconsistent with the benefits they had previously accepted. The court cited the holding in Atkinson Gas Co. v. Albrecht, 61.3 among others, in support of its position, although in that case the court had refused to apply the doctrine of quasi estoppel since the lessor, prior to accepting the 59 Id. See also Hunter Co. v. Shell Oil Co., 31 So.2d 10 (La. 1947). 60 See, e.g., Jones v. Bronco Oil & Gas Co., 446 So.2d 611 (Ala. 1984). 61 See, e.g., Ark. Code Ann (a) and N.D.C.C WL (Tex. App. June 23, 2009) Quasi estoppel, unlike equitable estoppel, does not require proof of a false statement or detrimental reliance. Rather, it precludes a party from accepting the benefits of a transaction and then taking a subsequent inconsistent position to avoid corresponding obligations or effects. Id at * S.W.2d 236 (Tex. App. 1994).

15 Keeping the Lease Alive royalty payment, had consistently maintained the position that the lease had terminated due to cessation of production [3] Force Majeure The force-majeure clause was developed to address circumstances that would otherwise cause the lease to terminate. 62 While the theory of force majeure has existed for many years and embodied the concept that a party could be relieved of its obligations if its performance was prevented by causes beyond its control, such as acts of God, its scope and application are now dependent upon the specific language of the force-majeure clause in the lease. 63 Whether the force-majeure clause extends the lease term set forth in the habendum clause is also dependent upon the language of the two clauses. 64 The force-majeure clause will excuse nonperformance only when caused by circumstances beyond the reasonable control of the lessee or when the event was unforeseeable at the time the parties entered into the lease. 65 The impossibility to comply with the lease must arise out of the nature of the act to be done, not the lessee s inability to perform the act. For example, in Erickson v. Dart Oil & Gas Corp., 66 the Michigan Court of Appeals ruled that the force-majeure clause did not excuse the lessee s nonperformance, which was due to delays in receiving drilling permits. The court found that the delays were foreseeable and that [w]here governmental action is alleged to be the cause of delay, the parties to the lease are presumed to have contracted with knowledge of any preexisting law that could have caused delay. 67 The parties are presumed to know 61.4 See also Scilly v. Bramer, 85 A.2d 592, 594 (Pa. Super. 1952) and Kyle v. Wadley, 24 F. Supp. 884, 888 (W.D. La. 1938) where the courts held that the mere acceptance of royalties did not preclude the lessor from canceling the leases for failure to develop. 62 See e.g., Baldwin v. Blue Stem Oil Co., 189 P. 920 (Kan. 1920). 63 Sun Operating Limited Partnership v. Holt, 984 S.W.2d 277, 283 (Tex. App. 1998) (lessee not required to avoid, remove, or overcome the effects of force majeure unless clause so requires); and Moore v. Jet Stream Investments, Ltd., 261 S.W.3d 412, 422 (Tex. App. 2008) (unless the lease provides otherwise, due diligence is not required to remedy force majeure). 64 Compare Sun Operating Limited Partnership v. Holt, 984 S.W.2d 277, 286 (Tex. App. 1998) with Gulf Oil Corp. v. Southland Royalty Co., 496 S.W.2d 547, 552 (Tex. 1973). 65 Hydrocarbon Management, Inc. v. Tracker Exploration, Inc., 861 S.W.2d 427, (Tex. App. 1993). But see Perlman v. Pioneer Ltd. P ship, 918 F.2d 1244, 1248 (5th Cir. 1990) (court erred when it interpreted the clause to require that the event be unforeseeable or beyond plaintiff s control) N.W.2d 150 (Mich. App. 1991). 67 Id. at 155.

16 23-16 Mineral Law Institute the regulatory agency s requirements when they enter into the lease. If the regulation is within the control of the lessee, the force-majeure clause does not protect the lessee. The force-majeure clause has been found inapplicable when delays were caused by the lessee s failure to comply with the Texas Railroad Commission s financial assurance requirements and when a well was shut in by the Texas Railroad Commission due to lessee s failure to timely file production reports. 68 Similarly, in Perlman v. Pioneer Limited Partnership, 69 the court ruled that studies required by Wyoming state officials before permits would be issued did not excuse the lessee s failure to perform. The force-majeure clause does not serve to extend the lease when the lessee is in bankruptcy, 70 although at least one Texas court has found that the force-majeure clause is extended by involuntary bankruptcy Maintaining the Lease During the Secondary Term [1] Dry Hole and Cessation of Production Clauses Many leases combine the dry hole clause with the cessation of production clause (e.g., if lessee should drill a dry hole, or if after production is obtained, production ceases from any cause, this lease shall not expire if lessee commences additional drilling or reworking operations within sixty days thereafter and they result in production being obtained ). What constitutes a dry hole and when does production cease for these purposes? Compare the mechanical analysis of the Texas Supreme Court in Sunac Petroleum Corp. v. Parkes 72 with that of the Wyoming Supreme Court in LeBar v. Haynie. 73 In Sunac, the lessee pooled the lands in question with other lands for gas purposes only three days before the primary term was to expire. The following day, drilling operations were commenced on land within the pooled unit, but not on the 160 acres covered by the lease. The well was completed as an oil well. Sixty-eight days after the expiration of the primary term of the lease and 13 days after the completion of the oil well, a second well was commenced, this time 68 See, e.g., Moore v. Jet Stream Investments, Ltd., 261 S.W.3d 412, 421 (Tex. App. 2008); Atkinson Gas Co. v. Albrecht, 878 S.W.2d 236, (Tex. App. 1994) F.2d 1244, 1248 (5th Cir. 1990). 70 See Champlin Petroleum Co. v. Mingo Oil Producers, 628 F. Supp. 557, (D.Wyo. 1986); Webb v. Hardage Corp., 471 So.2d 889 (La. App. 1985). See also Morton Valley Oil & Gas, Inc. v. Nelson, 1998 WL (Tex. App. Mar. 5, 1998) (unreported); and In re Trigg, 630 F.2d 1370 (10th Cir. 1980). 71 Gilbert v. Smedley, 612 S.W.2d 270 (Tex. App. 1981) S.W.2d 798 (Tex. 1967) P.2d 1107 (Wyo. 1976).

17 Keeping the Lease Alive on the particular 160 acres in question. It was completed as a producing oil well. The court reviewed the applicable provisions of the lease 74 and concluded that (1) the first well did not save the lease since it was an oil well and the pooling clause only applied to gas units, (2) the well could not be considered a dry hole for purposes of the 60-day provision since it was a producer, and (3) there had not been a cessation of production from the well triggering that provision. 75 In LeBar, the well at issue was drilled over the end of the primary term to a depth of 6,744 feet. On July 13, 1973, casing was run and the rig was released. One month later, another rig was moved upon the well, the well was deepened to 7,115 feet, commercial production was discovered, and the well was completed as a producer on October 2, The lessors argued that the well had been completed as a dry hole and that the subsequent operations were really a re-entry and re-deepening of the once-completed well after the lease had expired. The court upheld the finding of the trial court that the well was completed on October 2, not July 13, even though a total of 96 days elapsed between the date on which drilling was commenced and the well was completed as a producer. 76 Where a lease does not contain a cessation of production clause, in an effort to mitigate against the harshness of automatic termination, courts have developed the temporary cessation of production doctrine, reasoning that the parties must have contemplated that temporary interruptions in production would occur from time to time due to mechanical breakdowns, reworking operations, and similar problems. The lessee seeking the doctrine s protection carries the burden of demonstrating that the cessation is temporary and not permanent, so the outcome hinges on the particular facts of each case and can lead to some unusual results. For example, in Ridge Oil Company, Inc. v. Guinn Investments, Inc., 77 two lessees, Ridge and Guinn, obtained working interests under a single 1937 lease through assignments. Ridge shut in the only two producing wells, both located on its tract, for approximately 90 days with the express intent of terminating the 1937 lease. With certain of the mineral owners, Ridge 74 If prior to discovery of oil and gas on said land Lessee should drill a dry hole or holes thereon, or if after discovery of oil and gas the production thereof should cease from any cause, this lease shall not terminate if Lessee commences additional drilling or reworking operations within sixty (60) days thereafter.... Sunac, 416 S.W.2d at See also Rogers v. Osborn, 261 S.W.2d 311 (Tex. 1953), where the court also strictly construed the savings clause language in finding that the lease had terminated. 76 The court observed: [T]his writer believes that he may personally opine, without serious damage to the law, that prudence would always dictate testing of all possible production horizons in unproven areas. LeBar, 552 P.2d at S.W.3d 143 (Tex. 2004).

18 23-18 Mineral Law Institute then took a new lease that covered both tracts. Guinn argued that the lease had not terminated as to its tract because the cessation of production on the Ridge tract was temporary. The court held that when the mineral owners in the Ridge tract executed new leases with Ridge, they effectively terminated the 1937 lease as to the tract, and production by Ridge from the Ridge tract was thereafter performed under the new lease, not the old one, and the cessation of production from the Ridge tract had thereby become permanent as to the old lease. Similarly, in Duncan Land & Exploration, Inc. v. Littlepage, 78 the Texas Railroad Commission had ordered a well shut in for testing to determine if the well was producing sour gas in excess of allowable limits. The shut-in period extended for over six months while three separate tests were conducted, the last of which conclusively showed that the well was in compliance. Despite the existence of the shut-in order, the lessee periodically produced the well during the shut-in period. The lease contained a provision that it would terminate if no commercial production was obtained from the tract in excess of 90 days. The lessor sought to terminate the lease on the basis that the production from the well in violation of the Railroad Commission s order did not constitute production that satisfied the 90-day clause. The court held that the lease had not terminated. It noted that the lessee had to endure the Railroad Commission s plodding efforts... (and that) he was mired in a complex Catch-22 situation that was largely out of his control... either violate the shut-in order and keep his lease or abide by the order and lose the lease. 79 It concluded that the lessor should not be able to bootstrap himself onto the Railroad Commission s inherently public powers to take advantage of [Lessee] in connection with their inherently private lease. 80 The following factors have been considered in determining whether the cessation of production was temporary : (1) The cessation period. 81 (2) The cause of the cessation. It was thought that the Texas courts limited the application of the doctrine to a sudden stoppage of the well or some mechanical breakdown of the equipment used S.W.2d 318 (Tex. App. 1998). 79 Id. at Id. at Compare Saulsberry v. Siegel, 252 S.W.2d 834 (Ark. 1952) with Logan v. Blaxton, 71 So.2d 675 (La. App. 1954).

19 Keeping the Lease Alive in connection therewith. 82 But in Ridge Oil Co., Inc. v. Guinn Investments, Inc., 83 the Texas Supreme Court adopted a much more liberal standard, holding that the temporary cessation of production doctrine applies in a wide variety of circumstances. (3) The lessee s diligence in attempting to restore production. 84 A lessee might be better off if the lease does not contain an express provision covering the cessation of production. For example, in Samano v. Sun Oil Co., 85 the court held that the 60-day limitation period in the habendum clause applied to the secondary term, and the lease terminated because of a 73-day cessation of production. But in Pack v. Santa Fe Minerals, 86 even though the habendum clause limited cessation of production to 60 days, the court held that the lease did not terminate when the lessees had shut in the wells in excess of such period so that they could overproduce in the winter months without violating their allowables since the wells were capable of production at all times. [2] Shut-In Royalties Certain states equate production with actual production and marketing, while others hold that the term produced means capable of producing in paying quantities and does not include marketing of the product. 87 Most modern leases therefore contain a clause providing that the lease will be maintained by the payment of shut-in royalty while there is a gas well on the premises but gas is not being sold or used. 88 A typical clause reads as follows: Where gas from a gas well is not sold or used, lessee may pay as royalty $640 per well within 45 days after the expiration of each one-year period during which 82 See, e.g., Watson v. Rochmill, 155 S.W.2d 783 (Tex. 1941) and Somont Oil Company v. A & G Drilling, Inc., 49 P.3d 598 (Mont. 2002) (adopting the Texas test) S.W.3d 143, 152 (Tex. 2004), 84 See Locke v. Palmore, 215 S.W.2d 544 (Ky. 1948) (lease terminated when lessee capped the well and did nothing further); and Gillespie v. Wagoner, 190 N.E.2d 765 (Ill. 1963) (financial difficulties no excuse for lack of diligence). But see Natural Gas Pipeline Co. v. Pool, 124 S.W.3d 188 (Tex. 2003) (even if the lease expired because production had ceased, the lessees regained their leaseholds by adverse possession for the statutory 10- year period) S.W.2d 580 (Tex. 1981). See also Sun Operating Ltd. P ship v. Holt, 984 S.W.2d 277 (Tex. App. 1998) P.2d 323 (Okla. 1994). 87 Compare Freeman v. Magnolia Petroleum Co., 171 S.W.2d 339 (Tex. 1943), with Pack v. Santa Fe Minerals, 869 P.2d 323 (Okla. 1994). 88 See Tucker v. Hugoton Energy Corp., 855 P.2d 929 (Kan. 1993).